Last Week in Markets: Turns Out Markets Can Go Down

U.S. benchmarks officially entered correction territory for the first time since February 2016, with both the Dow (DJIA) and the S&P 500 (SPX) falling over 10% from their respective peaks. Although all three major US indices ended the week on a high note and finished just above the 10% correction threshold, last week marked the first major period of turbulence in financial markets since the 2016 presidential election.

The CBOE Volatility Index (VIX), a common measure of volatility in the marketplace, spiked almost 200% at one point last week.The spike put many hedge funds who had been shorting the VIX (i.e., betting on it going down) in a tight squeeze. The popular “short vol” trade, which had produced huge returns in the low-volatility bull market of the past 10 years, blew up in the face of many funds, resulting in margin calls that drove the market even further down.

The market’s recent downturn has claimed its first casualty, with LJM Partners, a Chicago-based hedge fund, crashing as a result of the spike in the VIX.The fund’s short vol trades ended up causing the fund to collapse by 82%, and it closed itself off to new capital. The fund may not be the last, as a number of hedge funds had very large exposure to highly-leveraged instruments designed to short the VIX. The collapse of these instruments, including a very popular one called the XIV, issued by Credit Suisse, has prompted many, including BlackRock, to call for increased regulatory scrutiny.

Dallas Federal Reserve President Robert S. Kaplan insisted that the Fed is still likely to raise interest rates three times this year. With robust job growth and low unemployment in the US economy, even with the recent stock downturn, the Fed sees little reason not to raise rates and trim their balance sheet.

Comcast may attempt to revive its merger with 21st Century Fox, after its original bid was turned down last year. Fox opted instead to accept Disney’s $52.4 billion bid, despite it being 15% less than Fox’s. However, the antitrust concerns that derailed the initial bid still remain.

Last week in markets…

Major U.S. benchmarks continued to suffer losses, in part due to the VIX blow up. The Dow Jones Industrial Average (DJIA) finished down 5.2% for the week, the Nasdaq Composite (COMP) closed down 5.1%, and the S&P 500 (SPX) finished down 5.2%.

European benchmarks felt the full force of a plummeting U.S. equities market, falling by equally significant margins.The UK’s FTSE 100 Index (FTSE) finished down 4.9%, hitting a 10-month low, and the German DAX Index (DAX) closed down 5.7%.

Asian markets, which have been moving synchronously with US stock performance from the day before, saw the worst losses of the lot.Japan’s Nikkei 225 finished down 8.1%. India’s BSE Sensex finished down 3.0% and Hong Kong’s Hang Seng closed down 9.5%.

Three key takeaways from last week…

Some investors managed to learn nothing from the 2008 financial crisis. The spike in the VIX and the subsequent destruction of inverse VIX products is a perfect example of this. Back in 2008, financial institutions fell victim to the gambler’s fallacy. Mortgages had been so reliable in the past that banks believed it would always be that way, without bothering to look under the hood. As a result, their exposure to very highly-leveraged derivatives of mortgage-backed securities was unbelievably high. So when increasing numbers of people defaulted on their mortgages, what would have been a dent in profits and a mini-recession turned into a financial meltdown and the worst recession since the Great Depression. Fast forward to 2018, and many funds seem not to have learned from the mistakes of 2008. To take advantage of the low-volatility post-2009, banks made markets for highly-leveraged products designed to short the VIX. Many funds took advantage of these products to produce huge returns. Even as volatility began to creep up towards the end of January and repeated warnings about these products were issued over the years, these funds believed the myopic “short vol” trade would always pay off. So, when bond yields predictably started to rise and investors rotated money from equities into T-bills, the VIX predictably spiked, causing these products to blow up, and when the issuers of these products came for margin calls, the funds that owned these products were forced to dump more assets, turning a slight dip in the market into a full-blown correction. The analogy isn’t perfect, but it seems that even after the 2008 financial meltdown, some people just haven’t learned. In fact, even now, with volatility as high as it is and a further market dip a strong possibility, retail investors are moving moneyinto these products. Hopefully more retail brokerages will follow Fidelity’s move and ban these products to save retail investors from themselves.

This correction might be exactly what the Fed was hoping for.The Fed and Treasury officials that have publicly discussed the latest market correction seem quite nonchalant. Treasury Secretary Steve Mnuchin declared that markets are “functioning very well.” New York Fed President William Dudley dismissed the correction as “small potatoes.” Dallas Fed President Robert Kaplan went even further, calling the correction “healthy.” In some ways, their collective message is a good sign for the Fed, indicating the central bank has learned from its pre-2008 mistakes and has finally dropped the laissez-faire attitude of former chairman Alan Greenspan towards asset bubbles. With much of new inflation going into asset prices instead of the CPI, it has become imperative for the Fed to “lean against” asset price bubbles to prevent calamitous collapses like the dot-com bubble burst and the 2008 financial crisis, which it seems like they’re doing now. However, while good in the long-term, these moves are painful in the short-term, and their success hinges on central bank independence. With Republicans poised to pump an economy at full employment with more stimulus than Congress did in 2008, if the Fed pulls the brakes, Trump may intervene. Of course, the last time a sitting US president tried this, it ended in stagflation – years of runaway inflation coupled with a crippling recession .

Market performance this upcoming week may hinge on the CPI report.The most important event of this week might be Wednesday’s release of January’s CPI report, which analysts forecast to stay at 2.1%. Worries about inflation due to the uptick in wages and the tightening of the labor market helped sink the market the last couple weeks, and if the CPI shows higher-than-expected inflation, it could send markets into another tailspin. Of course, even if inflation doesn’t exceed expectations, a rebound in markets is dependent on investors getting out from under the mess created by the VIX. If volatility calms down – which is a huge if, considering the VIX spike has led to record long positions in the VIX futures market – it’s possible that the market bounces back irrespective of Q4 earnings reports.

Featured image courtesy of Trading and Investment News

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Siddharth Srivatsan

Sid is a sophomore from Ashburn, Virginia (NoVA!) planning on double majoring in Mathematics and Economics. He enjoys backpacking, and DJ’s a radio show on WSRN-FM. You can probably catch him watching Law & Order or reading The Economist.

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